THE BULL MARKET REPORT for April 24, 2017
The Week Ahead
Global tensions are escalating. Since the United States dropped the Mother of all Bombs (MOAB), the world has come to learn that President Trump’s words carry weight. The newspapers are filled with stories of military angling between Russia, North Korea, China and the US. Peace through strength will hopefully prevail, which will be a major boost to equity markets, but in the interim, we are seeing elevated volatility as fears run rampant. Economic fundamentals remain great as optimism is at record highs and many bankers such as JP Morgan and Wells Fargo expect the optimism to translate to real growth in the economy in the near-future.
There is always a bull market here at The Bull Market Report! This week we highlight the following securities: Mazor, PayPal, Shopify, Digital Realty Trust, Care Capital, and Amazon.
Highlights From The Past Week
More Executive Orders From Trump. As pressure mounts on Trump to post some victories within the totally arbitrary window of the "First 100 Days," the President this week joined Treasury Secretary Steven Mnuchin to sign a combination of executive orders and memos targeting the reduction of tax regulations and certain components of Dodd-Frank. The executive orders and memos signed are expected to 1) initiate a review and potential unwind of executive orders signed by Obama in 2016 to limit corporate inversions and 2) initiate a thorough review of the orderly liquidation authority granted to the Federal Deposit Insurance Corp under Dodd-Frank.
Government Shutdown Looms. The Trump administration is quietly preparing for the possibility of a government shutdown, even though the president and his staff believe one is unlikely to occur. We will know at the end on Friday if the government can reach a deal. We expect Washington to figure it out in the 11th hour as they usually do, but we admit the risk of the government’s potential inability to come to consensus on how to manage its finances poses a risk to the bull market and may present volatility next week. In fact, the Vix (^VIX) has risen from 11.42 on March 29th to 14.63 today.
Oil Recovery Update. Global oil inventories are falling because of OPEC and non-OPEC production cuts, but the road to market balance will be long. Production cuts have removed approximately 1.8 million barrels per day from the world market since November. The latest IEA Oil Market Report stated, “It can be argued confidently that the market is already very close to balance.” What does that mean? Market balance means that production and consumption are approximately equal. That is an important first step for a market in which production has exceeded consumption for most of the last 3 years, but it hardly means that $70 oil prices are around the corner.
BMR Companies and Commentary
Mazor Robotics (MZOR: $36, +15% - all percentage changes in this report are for the week.)
The CEO of Mazor Robotics, Ori Hadomi, our beloved surgical robotics maker was on TV on Thursday. Shares of Mazor jumped on the publicity, among other reasons.
Hadomi explained that Mazor derives revenue from three pillars. It sells the robots themselves for about $1.1 million each. It sells the disposables the robot consumes, and it offers service and support. The company has always been focused on the patient, he continued, which is why he's privileged to be in this business. Mazor machines are seeing six times fewer complications and 10 times lower numbers for repeated procedures, and the hospitals that have Mazor robots are promoting and marketing the fact that they can offer procedures that others can't, generating new business for them that they didn’t have before. Hadomi also spoke about his company's partnership with Medtronic (MDT: $80), saying there are many synergies in culture and mission, and both are the leaders in their respective areas.
Mazor announced that it has received the FDA clearance for its Mazor X Align software. Mazor X Align software is designed to assist surgeons in planning spinal deformity correction and spinal alignment for procedures performed with the Mazor X Surgical Assurance Platform.
The new software is being demonstrated this weekend at the 2017 American Association of Neurological Surgeons Annual Scientific Meeting in Los Angeles. Mazor X Align will be initially released to select customers in early May, followed by a widespread release in the second half of 2017.
Mazor X Surgical Assurance Platform is a transformative guidance system for simplifying spine surgeries. Strong demand for Mazor X systems during the first quarter brought the total number of its orders to 40 since its introduction in the second half of 2016. The company ended the first quarter with an order backlog of 14 Mazor X systems and will deliver these in 2017. It is slated to report financial results for the first quarter on May 10th.
BMR Take: The company is putting every penny into its growth strategy and is not profitable and won’t be this year. Street estimates call for the company’s earnings to turn positive in 2019. With the inflection point in sight, we think EPS growth is coming and are happy to participate in what is shaping up to be an exciting stock. The stock has reached our Price Target of $36. Since we added the stock at $16 in June we are up 128%. We are hereby raising our Price Target to $44 and raising our Sell Price from $28 to $32. We don’t want to give away these amazing gains.
PayPal (PYPL: $44, +3%)
Earlier this week, it was announced that PayPal and Google will be partnering to integrate PayPal’s mobile payment options into Google’s smartphone payment app, Android Pay. No specific details of the arrangements were revealed, but according to Fortune, “PayPal’s chief operating officer, Bill Ready, said that his company’s partnership with Google will be implemented in the coming weeks.”
Executives at both Google and PayPal hope that the addition of PayPal as a funding source for Android Pay will serve to increase the number of smartphone owners who actively use Google’s digital wallet, while also making PayPal a more common choice for consumers making in-store purchases.
For years, PayPal has led the industry. Last year, PayPal processed more than 6 billion mobile transactions worth more than $350 billion. PayPal holds a commanding lead in the mobile payments industry, with 76% of digital wallet users reporting that they used PayPal.
BMR Take: PayPal is a one of the biggest growth stories of our generation. The company has 200 million users compared to Facebook’s 1.9 billion users. That leaves room for 10x growth still!
Shopify (SHOP: $76, +8%)
Shopify announced its new free Chip and Swipe card reader for in-person selling. With EMV support, the new Chip and Swipe reader lets any merchant in the United States sell offline in a fast and secure way. The card reader was launched at Unite, Shopify’s annual partner and developer conference.
Shopify makes every aspect of starting, running and growing a business easier. With the new Chip and Swipe reader, business owners can have the full power of Shopify behind them when selling in-person. The reader seamlessly connects with a seller’s Shopify store, eliminating the need for multiple systems to run a single business. Merchants benefit from the ability to manage their entire business from just one place and do not need to spend hours updating in-person sales with those made on their online store.
The first piece of hardware created in-house by Shopify, the new reader’s design was created using extensive research and user-experience feedback from their merchants. The Chip and Swipe reader is made for selling at festivals, pop-ups and markets. Unlike other readers that must plug into a headphone jack, the reader features wireless functionality and an extra-long battery life. The card reader was also developed to grow with business owners as they move from casual selling to a permanent retail location.
BMR Take: What can we say, Shopify is plugged into the massive growth of online, mobile e-commerce. Street estimates see sales growing from $390 million last year to $600 million this year to $1.4 billion by 2020. We saw a new all-time high this week ($78) and expect a LOT more from this stock.
Digital Reality Trust (DLR: $113, +3%)
Digital Realty, a leading global provider of data center, colocation and interconnection solutions, announced its 10th consecutive year of "five nines" of uptime – with 99.999 percent availability throughout 2016.
We are thrilled that the company has reached this important milestone, which reflects a steadfast commitment to developing and delivering the world's most dependable data center solutions. The company’s data centers are built and operated to rigorous standards by the most talented and best-trained team in the industry, which allows the business to consistently deliver solutions that provide the reliability customers require to run their businesses.
Digital Realty has 145 properties, encompassing approximately 23 million square feet in 33 metropolitan areas around the world. The company's global portfolio and comprehensive solutions enable their customers to expand from a single cabinet to a multi-megawatt facility as their needs grow, with no change in providers and no interruption in service.
BMR Take: With a 3.3% dividend yield and EPS power of $2+, the stock is a stable performer we think that should add nice gains in your portfolio.
Care Capital Properties (CCP: $28, +3%)
Care Capital Properties announced that it has entered into a definitive agreement to acquire six behavioral health hospitals in a sale-leaseback transaction for $400 million and to fund up to $50 million in capital expenditures to finance expansion and improvements in the portfolio. The properties are currently owned by affiliates of Signature Healthcare Services, one of the largest privately owned behavioral health care providers in the United States.
Upon completion of the transaction, which is expected to occur in Q2 of 2017, Care Capital will lease the properties to affiliates of Signature on a 10-year triple-net basis, with five renewals of five years each. The initial yield on the transaction is just under 9%, which is fantastic considering the leverage used to finance the deal was modest.
The acquired portfolio is comprised of six behavioral health hospitals located in California, Arizona and Illinois. The properties contain a total of 712 beds, and all six properties either have recently been expanded or are currently in planning or under development to increase bed capacity. The whole company now has about 350 properties, which is a nice size already and could potentially be much larger.
BMR Take: With an 8% dividend yield and a visible EPS run rate of $1.68, we like the value we see here.
Amazon (AMZN: $899, +2%)
As delivery firms struggle to manage overwhelming numbers of parcels, e-commerce giant Amazon is expanding its same-day Prime Now delivery service to include cooked meals and other items.
Amazon Japan said Tuesday it teamed up with Mitsukoshi's flagship store in Tokyo's Nihonbashi district to deliver foods such as deli fare and Japanese wagashi confections sold at the store. The online retailer also announced it has teamed up with pharmacy chains Cocokara Fine and Matsumotokiyoshi Holdings to deliver cosmetics and other daily supplies within one hour after an order is placed.
The Prime Now service, launched in 2015, has been available to Amazon Prime members who pay an annual fee of $36. Customers may choose items via a smartphone app with a minimum purchase of at least $23. The service is currently available to customers in parts of Tokyo, and a few other prefectures.
Amazon is also reportedly considering a rollout of same-day delivery service of fresh food including fish and vegetables. Similar options already exist in other countries such as the United States and the United Kingdom.
Competition over same-day delivery of groceries via online shopping is heating up in Japan but when Amazon puts its mind to something, great things usually happen.
BMR Take: We seem to say this every week: The Amazon innovation machine did it again. With so many new services being launched like the latest in Japan, earnings are expected to go to $20 in 2020 from $7 this year. The ride is far from over.
US Economic Outlook
Industrial production will look decent on the surface; we forecast it to have risen 0.4% in March. Mining production will likely increase, consistent with rising rig counts, as noted above in the Key Market Measures chart. Manufacturing production will be weak and is forecast to have dropped 0.4% in March, held back by Autos.
Unseasonably warm weather in January and February likely boosted housing starts, but temperatures were more seasonably normal in March. Also, an East Coast snowstorm should have hurt starts temporarily. Other housing data will look better, as we expect existing-home sales to have risen from 5.48 million annualized units in February to 5.58 million in March.
The first two regional manufacturing surveys for April are expected to have weakened, generally consistent with other survey-based data that have begun to surrender some of their post-election gains.
Financial market conditions also bear watching. Long-term interest rates have slid, which is a positive for investment and housing. However, equity prices have struggled recently. Though the immediate implications are minor, further declines would lend more downside risk to our outlook for consumer spending. Volatility could continue to rise because of geopolitical tensions, particularly in North Korea. Tensions are building between there and our forecast does not include a military conflict. Odds favor this conflict being eased with China imposing economic sanctions on North Korea.
We wouldn’t be surprised if the VIX continues to climb. The VIX curve is strangely inverted. In other words, investors expect volatility to be higher in the near term but revert to lower levels in the longer term. Volatility is normal and the economic implications of the VIX rising to the level consistent with fundamentals are not significant at the moment. If there were a sudden, significant and persistent increase in the VIX, there would be economic costs which would weigh on hiring and investment.
Goldman Sachs (GS: $217) had another bad week, dropping $7 or 3%. We removed the stock from our portfolio on Jan 19th at $232. Weighing on the bank’s results was a 2.4% decline in trading revenue to $3.36 billion. But the overall numbers were surprisingly good in our opinion: Profits per share of $5.15 were higher than the $2.68 it earned during the same period of 2015, but below Wall Street’s expectation for $5.31 a share. Revenue, meanwhile, came in at $8.0 billion, 27% above the year ago period, but missed the Street’s target of $8.44 billion. Wall Street is just funny sometimes. Those numbers appear pretty good to us. If the stock gets down below $200 we would be buyers again. Goldman is a money minting machine and they had a little hiccup last quarter, but you can’t hold this company down for long.
Home Depot (HD: $150) sets a new all-time high this week. The market cap is now $180 billion. Huge. Our Target is $160 which we are keeping, but we are raising our sell price from $130 to $144. We don’t want to lose these gains. We added them at $118 over a year ago and are up 27% on this powerful company.
Microsoft (MSFT: $66) quietly set a new all-time high this week. Go Bill Gates! The stock is up 14% since the election. Not bad for a company worth over $510 billion. Our target is $70 which we would love to see this summer. Our Sell Price remains the same: “We would not sell Microsoft.”
Splunk (SPLK: $62) had another good week, up 5%, and it is approaching its 52-week high of $66. Our Target is $70. Earnings are coming up in the 3rd week of May and we are quite optimistic that we will see strong revenues and earnings to keep this stock going higher.
Visa (V: $91) sets a new all-time high this week. We love this $210 billion market cap company. Ah – the business of MONEY. How can you beat it? The company reported revenue of $4.48 billion, up from $3.63 billion from a year ago, a gain of 23%. Wow. Excluding one-time items, Visa earned 86 cents a share, beating analysts' average estimate of 79 cents. The company said total payments volume jumped 37% to $1.73 trillion in the second quarter. The growth in payments volume was helped by the addition to Visa's results of Visa Europe, a former subsidiary Visa bought in June last year in a deal worth $23 billion. Visa Europe made up nearly a fifth of total payments volume. This company is truly and international company. We can’t wait to raise our Price Target of $95 to $110 when it hits $95. We would not sell Visa.
This stuff scares us here at The Bull Market Report. What more can we say? Well, Herbert Stein had a few things to say about these types of things. Herbert Stein (August 27, 1916 – September 8, 1999) was an American economist, a senior fellow at the American Enterprise Institute. He was chairman of the Council of Economic Advisers under Richard Nixon and Gerald Ford. Stein was the formulator of "Herbert Stein's Law," which he expressed as "If something cannot go on forever, it will stop," by which he meant that if a trend cannot go on forever, there is no need for action or a program to make it stop, much less to make it stop immediately; it will stop of its own accord. It is often rephrased as: "Trends that can't continue, won't."
A Word From Gary Jefferson
Jefferson Financial Group
First Vice-President, Investments
UBS Financial Services, Inc.
The pundits are all hopping on the "sentiment-remains-depressed-by-geopolitical-risks" bandwagon. Maybe, but sabre rattling has never really been a reliable forecaster of market direction. It's more likely that sentiment is flattening out because the Atlanta Fed’s real GDP forecast for the first quarter of 2017 is a measly 0.6% as of April 7th. Everyone knows the Fed would prefer to have some additional leeway to combat future economic weakness, but with that paltry number it may need to reconsider its current projected pace of rate increases as 0.6% is not near enough "runaway growth” to use as an excuse for rate hikes. Nor does it indicate inflation is going to become an urgent issue anytime soon.
There are other things worrying the market besides geopolitical risks. Transports, which have always played a meaningful role in measuring market moods, have fallen from a high of around 6% in March to the low for the year of about -1.5%. And small cap stocks, which roared at the end of 2016, have completely stalled out so far this year.
Maybe the market will digress back into the "bad news is good news". Hopefully not. Many pundits are now talking up a gridlock scenario where all the Republican squabbling and Democratic grandstanding will create the type of gridlock that the market thrives on where Washington does little to interfere with the private sector. Again, hopefully not.
Another pause in rate hikes means earnings aren't there and the economy is still stuck in low gear. That would be a serious headwind against further market gains if you consider that in the first quarter the S&P 500 was up 5.5% versus that 0.6% GDP performance. That kind of stock market performance needs better GDP support. We still feel that, contrary to what the mainstream media would have you believe, the Trump growth agenda has not been derailed. Yes, corporate tax reform hasn't gone anywhere. Basically, it is not happening as fast as many hoped for, but what else is new in the world of politics and bureaucracies?
What we still see in the countless projected earnings reports we have read is that, even with a derailment of the growth agenda, earnings this year will beat last year. Earnings should remain the catalyst for a decent year in which stocks end up higher than they are today.
The High Yield Corner
Special to The Bull Market Report
by Michael Foster
There’s one data point that we find particularly worrisome: the 10-year Treasury constant maturity minus the 2-year Treasury constant maturity. This somewhat esoteric macroeconomic metric effectively measures the market’s expectations for government bond yields in the short and long term. By comparing the two side by side, we can see how the market expects economic growth, inflation, and bond yields to trend in the future.
This metric was in a constant decline from its peak in 2014 to the Trump election for one simple reason: Expectations about inflation were getting weaker and weaker. Of course this made sense in a world where oil prices seemed to be in a never-ending freefall, so it’s not surprising that the trend was virtually uninterrupted until November’s election. Then it jumped to its highest point in a year and has been steadily declining since.
Why does this matter? Because that short-term spike, combined with the inevitable decline afterwards, indicates that the bond market simply doesn’t really believe that inflation and economic growth are going to spike. What’s more, the bond market also doesn’t really believe the Federal Reserve is going to raise interest rates three times in 2017.
We have been somewhat agnostic on the matter. While the bond market has made this pronouncement loud and clear, the stock market has been saying the opposite. The S&P 500’s P/E ratio keeps climbing, and the rationale behind the higher valuations rests largely on a belief that price inflation and strong economic growth will boost earnings. We have recently written about the 12% EPS growth expectations for 2017; those expectations have not disappeared. Thus it’s no surprise that the S&P 500 is still up 5% even after the slight pullback following early March’s peak.
As high yield investors, we are constantly trying to reconcile the stock and bond markets. There are two reasons for this. Firstly, corporate bonds, BDCs, preferred stocks and convertible bonds are a tad schizophrenic. Sometimes they trade with equities, sometimes they trade with bonds. When both markets are in agreement, there’s no problem; when they disagree, however, there’s a chance for a major price correction. Since the run-up in stocks and in bonds has caused all of these instruments to perform strongly, the chance of a downside correction, if not a brief bear market, deserves serious attention.
The other reason we always try to reconcile both markets is because our high yield strategy involves an incorporation of stocks and bonds. Bull Market Report pick AGIC Equity and Convertible Income Fund (NIE: $19.51) is a perfect example of this strategy at work. This fund has both stocks and convertible bonds in it, and its net asset value can often fluctuate because of one or other side of the portfolio. The balanced approach means the fund has massively outperformed the market, rising 6% year-to-date while paying an 8% dividend. It also outperformed the broader market this week, with a 1.3% boost.
Compared to standalone bond funds, the AGIC fund has been a massive outperformer. Bull Market Report pick Invesco Municipal Trust (VKQ: $12.68) was flat for the week and is up a bit over 3% year-to-date. Here’s a question for us all: Why is the AGIC fund performing so much better, despite the fact that the Invesco fund and other municipal bonds had a major correction in 2016 and are in recovery mode, while AGIC had an awesome 2016?
The key to this puzzle is in conflating what’s going on in the bond markets and the stock markets. AGIC is doing better than bonds alone because it has both equities and bonds, and both markets are doing extremely well for different reasons. Stocks are strong because of higher earnings expectations, and bonds are strong because the market doesn’t believe the Fed’s threats to jack up yields several times in the near term. We don’t either!
Can we merge both of these hypotheses into a coherent market view that makes sense?
We can. Both markets seem to be telling us that company performance is going to be strong but this will not result in runaway inflation that will give the Federal Reserve the justification it needs to raise interest rates. How can stronger earnings and more sales NOT translate into inflation? This seems like economic gibberish from a micro or a macro perspective - but it actually makes a lot of sense if you synthesize the two. Stronger earnings and more sales on the micro level can easily be offset by weak population growth; keep in mind that the population growth rate in the U.S. has fallen from 1.0% in 2008 to 0.7% in 2013 and has fallen below 0.7% this year for the first time since the 1930s.
Of course, if Donald Trump’s promises to lower immigration and deport illegal/undocumented immigrants are fulfilled, this will put downward pressure on population growth even further. Regardless of your political beliefs on the topic, the economics of such a dynamic are quite simple: Fewer people will mean lower GDP growth. However, that doesn’t mean you’ll have lower GDP per capita growth or that companies won’t be able to make higher profits in U.S. dollar terms.
We actually have a historical precedent for such a trend: Japan. GDP per capita has been going up since the late 1990s to today despite the fact that total GDP has barely budged. In 1995, Japan’s GDP exceeded $5 trillion. Its GDP is $4.1 trillion as of the last reading in 2016. However, GDP per capita has gone from less than $40,000 in the middle 1990s to $45,000 as of the last reading. That’s not terribly great growth, but it is growth - whereas GDP in total has gone down.
We could see a similar situation in America: Fewer people but more GDP per person.
Of course this kind of GDP growth hasn’t really translated itself into strong earnings at Japanese companies because the country depends on exports and has faced growing competition from South Korea and China. And that’s where the comparison between Japan and America falls apart. America is a net importer, not exporter, so the loss of people could impact firms quite differently. As a consumption-focused economy, that higher GDP per person could result in higher consumption, thus higher sales and higher profits. Or it could give companies room to grow prices (thus increasing revenue per customer) without actually causing inflation (because there will be fewer customers, meaning total spending isn’t going up). Thus we would be in a world of weak inflation, weak aggregate growth, but strong growth per person and higher earnings. Good for bonds and good for stocks.
This kind of granular analysis is foreign to the talking heads, political pundits, and headline writers who are financially motivated to stir up controversy, anger, fear, and all sorts of portfolio-destroying emotions.
So the Fed is not going to face the kind of economic conditions that can justify raising interest rates significantly. At the same time, there is tremendous pressure on the Fed to raise interest rates, so we can’t expect them to lower rates either, unless the bond market shoots higher from here and rates collapse. In other words, a very slow pace of interest rate hikes alongside higher earnings is probably going to be the big macroeconomic story for the next couple of years.
Is this good or bad for high yield investors? We believe it’s very good for a number of reasons. Firstly, it means lower bankruptcies for junk bonds (default rates have been falling for quite some time). Secondly, it means higher earnings potential for companies (thus more bond issuances and more tolerance for higher interest rates on new issues). Thirdly, it means that big capital flows out of high yield investments and into safer Treasuries is unlikely to happen. (This was the big bear case for junk bonds in 2014, 2015, 2016 and it’s a tired thesis that has been proven wrong so many times that it’s no longer a big hindrance to high yield bond price growth).
Is there any reason this could be bad for high yield investors? Perhaps the biggest risk is of the market overpricing the upside of this high earnings/low interest rate paradox.
For that reason there’s good reason to remain cautiously optimistic and look closely at what happens in the bond and stock markets over the next few weeks. But that doesn’t mean it’s time to sell or start to worry.
Good investing,
Todd Shaver, Editor in Chief
Founder and CEO
The Bull Market Report
Since 1998
